Miller Howard Investment commentary for the second quarter ended June 30, 2024.
The investment world has been smitten with picking stocks based on free cash flow (FCF, defined as cash flow from operations minus capital expenditure) over the past decade. The basic idea of this approach is to favor capital-light business models or companies in “harvest mode,” meaning that capital investments have been made and now cash flow is plentiful. At Miller/Howard, we largely embrace this viewpoint, but our research-driven culture demands that we examine the quality of free cash flow. Looking under the hood, one issue leaps out—high levels of non-cash executive compensation at many companies, particularly non-dividend payers.
The use of stock or option-based compensation schemes is common across all industries. Accountants estimate the expected value of the awards and treat it as a cost when calculating net income. When it comes to cash flow, the cost of stock and option compensation is added back to net income because these awards have no current cash costs. For investors, it’s not that a check is in the mail—in contrast, a bill is coming. The ultimate cost of non-cash compensation will be higher the better a company does, taking the shine off the upside.
The good news is that cash flow statements tell us exactly how much of free cash flow is coming from companies using non-cash compensation rather than salaries and cash bonuses. Looking at the S&P 500 Index's core members (leaving out financials, real estate and utilities for which free cash flow is not a useful metric) over the past 10 years, companies without regular dividends have increasingly sourced their free cash flow from non-cash compensation. For the last two years, these non-dividend payers had roughly one-fifth of free cash flow come from using non cash compensation. In contrast, regular dividend payers consistently sourced much less of their free cash flow from stock-based compensation. In our opinion, with their more judicious use of non-cash compensation, dividend-paying firms are sending a clear signal that they are managing their businesses for the benefit of shareholders.
The Free Cash Flow Story
Before we analyze how investors may be missing the potential problems with heavy use of noncash executive compensation, let’s first review why investors have focused on free cash flow in recent years. From a stock-picking perspective, free cash flow margin, defined as free cash flow per dollar of revenue, has been an excellent predictor of total returns over the past 10 years. Stocks in the highest quintile of free cash flow margins have had more than double the returns of stocks in the lowest quintile.
High free cash flow margins suggest that firms can reliably convert revenue growth into higher levels of free cash flow. The key assumptions are that free cash flow margins will remain high revenue will grow, and most importantly, valuation does not matter given that free cash margins are entirely independent of stock prices.
Free cash flow yield, defined as the amount of the free cash flow per dollar of market capitalization, is a useful valuation metric. The quirk of the trailing decade is that the top four quintiles of free cash margins averaged roughly the same valuation, between 5-6% free cash flow yield, allowing investors to tilt towards high free cash flow margins without having to compromise too much on valuation (meaning free cash flow yield).
Let’s see how the free cash flow story intersects with dividend investing.
